I first took a 7% position in Cloudflare at $100 in late Feb thinking it’s “cheap” enough and then sold it during the March rally at around $125. I bought it again at $98 in early April, but sold it down to a 1.5% position a few days later at $90 (pre earnings) as I thought more about it. I finally sold it all after earnings at around $68. All in all, I didn’t lose money on Cloudflare but nevertheless I want to kick myself for buying a company that I was never very comfortable with.
I reflected hard on whether that’s the right thing to sell given how badly sold off it already is but ultimately I decided that there is a lot of further downside if my concerns are right.
There are some weaknesses in the Q1 numbers but that’s not the deal breaker. The key reason is its stated “zero profit” strategy . Here it goes.
(1) Weaknesses in Q1 numbers
The revenue for Q1 and Q2 guide are fine but the underlying - and leading - indicators like billings and large ($100K ACV) customer net adds show emerging signs of weakness. As a reminder, the 100K ACV customer group accounts for 1% by number but 58% of revenue and so it is a key driver of future revenue growth; but the nature of SaaS business is such that any weakness won’t show up in the revenue numbers until a few quarters later. Again, I can understand that the macro is challenging and if you and I are feeling fearful, so are companies. It’s not inconceivable that I.T. spend will take a bit of a hit at the margins for a couple of quarters. So I am giving them a pass for that.
Nevertheless, you can see that the net add numbers is now flatlined YoY and declining QoQ since the 21/09 Q.
21/03 21/06 21/09 21/02 22/03 100K ACV customer net adds: 117 143 172 156 121
(2) “Zero Profit” strategy
Now, here’s my key concern. The CEO has been saying consistently that they will manage to a breakeven profitability for years to come . Here are some quotes:
Q1 2022 earnings call
CFO: “And as a reminder, we intend to grow our operating expenses in line with the revenue, staying near or at breakeven and reinvest excess profitability back into the business to address the enormous opportunity in front of us.”
Analyst: “So are you basically sort of managing to kind of a breakeven non-GAAP operating income line, plus or minus a couple of million here, just to maximize the revenue?”
CEO: "So I think that we’ve been very consistent at saying that we are going to hold as close to breakeven on our operating margin as we can … if we showed massively positive earnings per
share, that would mean that we did something wrong because if we can continue to grow at the rates
that we’re guiding toward, there nowhere else we should be putting that money other than back into the
business … And again we are managing towards a breakeven on operating margin.
Q4 2021 earnings call
CEO: "For long as we can, we want our operating margin to hold just about breakeven and right where it’s been for the last two quarters. In other words, we’ve done something wrong if we beat significantly on EPS.
Q3 2021 earnings call
CEO: “We anticipate that we will hover just below or just above breakeven likely for years to come.”
Now, NET at close to a $1 bil run-rate, is where investors expect it to display operating leverage and grow its profitability rapidly (like what DDOG or CRWD had done - go look up their history) but NET’s CEO said there will not be profits for years!
And you can see that from their operating margin guidance: for the first time since its IPO, they guided to a decline in operating margins for the next quarter
Op margin guide for next quarter since IPO: -27% > -22% > -20.7% > -15.0% > -8.1% > -6.5% > -6.5% > -5.4% > -0.3% > 0.5% > -0.7%
This excuse of depressing profitability to grow its revenue is a familiar one and I heard the exact same thing from the CEO of fallen angels like Okta and Twilio. I am not sure whether they cannot or choose not to grow its profitability.
and look, if CRWD or DDOG can grow its revenue by 60% and 80% respectively, and still improve its margins year after year - why is it that NET has to keep its profitability zero for years to come, just to grow 50%+?
Investors can close one eye if you are still early stage (like SentinelOne) but will not forgive you once you hit revenue scale (~$1 bn run-rate) and yet still cannot grow your profit. They will conclude that your unit economics/business model is impaired and will abandon ship faster than you can say good bye.
Well, how low can the stock go?
Okta: 8x EV/NTM revenue (From 25-30x a year ago)
Twilio: 3.6x EV/NTM revenue (from 20-25x a year ago)
In both cases, they grew their revenue past $1bn but profitability stays at roughly zero (using the same reasoning as NET’s CEO).
Cloudflare is now at 20x EV/NTM revenue (from 80x a year ago).
So is 20x a floor to NET’s stock price?
In the current environment, low EV/revenue cannot provide a floor to your stock price if you are breakeven or loss making (for companies whose revenue has scaled). Investors are shifting to PE or P/FCF multiples for revenue-scaled companies and if the denominator is zero or negative, they can’t value it and EV/revenue becomes quickly irrelevant.
And this is actually how it should be. As someone who runs a small business in my day job, I know that I can’t pay my investors with revenue. I need to pay suppliers, workers, creditors and taxes first - finally I pay my investors with whatever is left. Investors stand last in line for any money that the company generates.
As a hypothetical thought exercise, if a company grows its business from $100 mil to $10 billion in revenue, but the unit economics sucks so badly that it cannot turn a profit in perpetuity, then the stock price is worth close to zero (barring some value for liquidation of its net assets).
It’s only in the 2020/21 madness that revenue becomes a proxy for profits or free cash flow. Its rightful place is only as a valuation measure for early stage sub-$1bn companies.
Ultimately, people should ask themselves whether they want to invest in a company that will not make any profit for years even when its revenue has scaled to multiple billions. What does this actually say about its unit economics and competitive moat?